Adobe: Shares Are Languishing, But AI Could Catalyze Growth (Rating Downgrade)

Summary:

• Adobe has a rich history and strategic roadmap in AI, intending to leverage it for business growth, despite market concerns over generative AI.
• Adobe’s four-pronged differentiation in AI rests on data, scale, talent, and a comprehensive portfolio; the recent launch of Firefly adds further momentum.
• There are inherent risks in the fast-evolving competitive landscape, with startups leveraging AI threatening Adobe’s market position.

We observe that Adobe (NASDAQ:ADBE) stock has recently been subjected to market pressures, resulting in its significant underperformance in comparison to other tech stocks. This is largely due to apprehensions about generative AI. Consequently, Adobe shares are currently trading at appealing levels. While we acknowledge that the market’s concerns are valid, particularly in light of the recent Chegg (CHGG) incident we previously discussed, we’d like to highlight Adobe’s extensive track record in AI investments. The company management has a credible strategy to utilize AI to stimulate business growth. The competitive landscape remains uncertain, but we propose that investors should contemplate the potential advantages Adobe could gain from generative AI, rather than presuming it will merely lose market share. In this piece, we will delve into Adobe’s AI proficiency, its strategy to conquer the market with AI, and offer a financial and valuation analysis. This will equip investors to form their own conclusions after conducting thorough due diligence.

Understanding Adobe AI

In 2017, we penned an article on Adobe Sensei, Adobe’s artificial intelligence service designed to significantly enhance the creation and delivery of digital experiences. At that time, we stressed the monumental importance of AI, a fact that was largely underappreciated. Adobe, however, was already pioneering with Sensei. In the following years, the company has consistently ramped up its investments, culminating in the announcements of Sensei GenAI and Firefly at the March Summit conference. Adobe anticipates that generative AI will broaden opportunities across all customer segments.

For high-end users, quicker content generation can boost productivity among creative professionals and business users, facilitating more personalized content creation. This, in turn, stimulates greater usage of Adobe’s downstream products. Adobe envisages that the Generative AI revolution will provide a substantial boost to their overall business, primarily propelled by the expected fivefold increase in content demand over the next two years, according to our due diligence with management. This coincides with an intensified market focus on large-scale personalization on an individual customer basis. In other words, providing an exceptional, tailored customer experience for each individual will accelerate the content creation cycle.

For lower-end users, generative AI can reduce barriers to creativity, with Firefly already demonstrating an increase in top-of-funnel leads. We certainly expect leads to grow significantly after Google integrates Firefly into Bard. Adobe’s differentiation in AI rests on four pillars: data, scale, talent, and a comprehensive portfolio. While generative AI has spurred the development of numerous creative solutions and apps, Adobe has systematically deployed its generative AI strategy.

Adobe’s management views its strategy as being in a unique position, largely attributed to several key factors. One of these factors is its use of commercially safe data. To avoid those legal and ethical issues, Adobe created an AI art generator trained solely on Adobe Stock images, openly licensed content, and public domain content, ensuring the generated content is safe for commercial use. This means that Adobe uses data that is free from potential copyright issues, providing customers with peace of mind when using generated content.

Another significant factor is the company’s scale. Adobe has been able to accumulate vast amounts of content, usage data, and workflow knowledge over the years. This wealth of information spans across hundreds of millions of users, ranging from creative professionals to business and consumer users. Leveraging such a scale allows Adobe to fine-tune its AI solutions to meet various needs.

Talent is also a crucial factor in Adobe’s unique position. The company boasts a robust team of AI experts and data scientists who are constantly innovating and pushing the boundaries of what is possible with AI. This talent pool has been instrumental in driving Adobe’s AI initiatives forward.

Lastly, Adobe’s comprehensive portfolio sets it apart. Adobe offers an array of products and solutions, with Firefly being one of the recent additions. This end-to-end portfolio allows Adobe to cater to various stages of content creation and delivery, providing a holistic solution for its customers.

The recent launch of Firefly has not only added to Adobe’s impressive product suite but also stirred interest within the AI expert community. The innovative nature of Firefly is drawing more and more industry experts towards Adobe, further strengthening its position in the market.

In our view, creating content with generative AI is just the beginning – this content then needs to be refined and integrated with other content within a personalized workflow before a final product is disseminated. Adobe’s product portfolio, spanning Digital Media and Digital Experience, is equipped to support this entire journey.

Risks

Owning shares in any company, including Adobe, comes with inherent risks, especially in the face of ongoing technological shifts such as the current surge in artificial intelligence. One such risk is the potential for new entrants, leveraging the capabilities of emerging technologies, to seize market share from established players.

Adobe, as an incumbent, is not immune to this threat. With the advent of AI, the digital image market has seen an influx of startups that are not only embracing this new technology but also using it to challenge traditional market leaders. Companies such as OpenAI, Midjourney, and Stable Diffusion, among others, represent this new wave of potential disruptors.

These startups often have the advantage of agility, being able to quickly adapt to changes and innovate rapidly due to their smaller size and less bureaucratic structure. They can focus their resources on a single product or solution, optimizing it with the latest AI technology to meet the specific needs of their target market.

In contrast, incumbents like Adobe, despite their resources and extensive customer base, may face challenges in rapidly adapting their broad product portfolio to incorporate new technologies. Additionally, being established players, they also have to balance between maintaining their existing product line and innovating for the future, which could slow down their response to market changes.

Finally, these new entrants are also not limited by legacy systems or pre-existing customer expectations, which can further accelerate their innovation and allow them to potentially disrupt the market.

We’ve already witnessed these dynamics with Canva, a nimble and innovative startup that has successfully carved out a share of the market previously dominated by Adobe, particularly in the hobbyist and “prosumer” segments. This development, we believe, compelled Adobe to attempt an acquisition of Figma at a considerably high valuation. This move seemingly underscored Adobe’s vulnerability to emerging startups such as Canva and Figma.

Investors are understandably apprehensive about a potential repeat of this scenario, this time involving AI-focused companies. The rise of AI startups in the digital image market could pose a similar threat to Adobe’s market dominance, possibly leading to strategic decisions reminiscent of the Figma acquisition attempt. Adobe’s potential susceptibility to such market disruptions emphasizes the importance for investors to consider these risks in their decision-making process.

Financial & Valuation

Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.

Adobe’s financial health is a compelling starting point in this analysis. The company’s Q1 revenue growth was 9.2% year-on-year, reaching $4,655 million and aligning with consensus estimates. This, along with a gross margin of 89.2%, demonstrates Adobe’s ability to generate robust revenues while maintaining strong profitability. The three-year compound annual growth rate [CAGR] of Adobe’s revenue stands at 16.4%, showcasing its consistent top-line growth. However, we would note that the company’s rapid deceleration in topline growth in recent years is a primary concern.

Furthermore, Adobe’s operating margin, despite a slight decrease from 46.8% to 45.8% year-on-year, is still impressive. This, combined with the fact that over the past three fiscal years, Adobe’s EBIT margin increased by 5.2% points, from 39.9% to 45.1%, underlines the company’s proficiency in effectively managing its operating expenses.

In terms of shareholder dilution, Adobe has shown commendable prudence. Over the past three years, it spent 7.4% of its revenue on share-based compensation (SBC), and, importantly, the number of diluted outstanding common shares decreased by 5.0%. This suggests that management effectively used share repurchases to more than offset shareholder dilution. As a result, EPS grew at a CAGR of 20.3% over the past three fiscal years, outpacing its revenue growth.

Adobe’s strong return on invested capital of 25.4% coupled with a manageable net debt of $4.1 billion (0.4 times its expected current-year EBITDA of $9.4 billion) underlines its solid financial footing and efficient capital allocation.

Turning to stock performance, Adobe’s stock has underperformed over the past year, returning 20% less than the S&P 500, or -13.7% in absolute return. However, we opine that this underperformance may present a potential buying opportunity if you believe the company could meet consensus estimates. The stock is trading 4.3% below its 200-day moving average and 26% below its 52-week high, which may offer an attractive entry point for potential investors.

Finally, regarding valuation, Adobe is trading at an EV/Sales multiple of 7.3, an EV/EBIT multiple of 16.3, a P/E multiple of 19.1, and an FCF multiple of 17.4. Despite premiums in EV/Sales, EV/EBIT, and P/E relative to the S&P 500, the company trades at an FCF discount of 10.7%. Furthermore, Adobe’s FY2 PEG ratio currently stands at 1.2 compared to the S&P 500’s PEG ratio of 1.5, a discount of 19.2%, which, when considering the company’s growth rate, may indicate that the stock is undervalued.

Although Adobe’s stock has underperformed in the past year, we believe that the company’s solid financials, coupled with its current valuation, present a potentially attractive investment opportunity. However, the competitive landscape, as we have discussed, is rapidly evolving, making it difficult to assess the company’s prospects, which may be enough to avoid the shares. As always, investors should carefully consider their own investment objectives and risk tolerance before making any investment decisions.

Conclusion

The shifting sands of the AI landscape and the resulting market dynamics present both challenges and opportunities for Adobe. While the company has displayed a robust response to AI advancements with strategic investments and innovations, it’s undeniable that emerging startups pose a real threat to Adobe’s market dominance. As we’ve witnessed with Canva and potentially with other AI startups, Adobe must continually adapt and innovate to retain its market position.

However, despite the market pressures and recent underperformance of Adobe’s stock, the company’s solid financial health and appealing trading levels may present a promising investment opportunity. Investors are urged to balance these potential rewards against the inherent risks in this rapidly evolving technological environment. Adobe’s journey in the AI era is undoubtedly one to watch, promising interesting developments for both the company and its investors.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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